As the market for sukuk kicks off, experts are once again betting on the UAE’s potential to become the centre of sukuk issuances in the world. But to become one, a mount of obstacles need to be removed first.
Currently, Malaysia still dominates the sukuk market. Sukuk issuance in Malaysia makes up nearly three-fourths of the entire sukuk market in the first nine months of 2010.
But the UAE has the necessary elements to be the centre of Mena and global Islamic bond issuances, a report from Dubai Chamber, said.
For one, the UAE is strategically located to bridge the financing gaps thank to its proximity to wealthy Arab states. It can also bridge the West and the East thanks to its favourable time zone.
In addition, Dubai has the first-mover advantage in terms of sukuk trading regime through Nasdaq Dubai where a sukuk can be listed through a simplified process. Dubai’s new and advance infrastructure also allows it to facilitate financial services efficiently.
Islamic bonds have gained prominence in the UAE lately as the demand for investment vehicles in conformance with Islamic laws has met issuance by government and corporate entities.
“The UAE is considered one of the top locations for sukuk issuance around the world and has created a transparent and benign environment for sukuk issuance and trading,” the Dubai Chamber Economist report, said.
After a big dive in debt issuance in 2008 and 2009, the market has begun to recover last year and this is set to continue from this year onwards.
Figures from Standards and Poor’s show that the sukuk market returned to growth in the first half of 2010 with global sukuk issuance topping $13.7 billion or nearly twice the $7.1 billion recorded during the same period in 2009. Kuwait Finance House predicts sukuk issuance in 2011 will surpass the $34 billion issued at the peak in 2007.
While small compared to the global pie, issuances from the UAE are considered substantial.
In November, the UAE’s largest Islamic lender Abu Dhabi Islamic Bank (Adib) closed a $750 million sukuk, marking the largest corporate issue out of UAE last year. Listed on London Stock Exchange and paying 3.745 per cent on semi annual basis, Adib's second sukuk was oversubscribed 4.8 times.
In December, National Bank of Abu Dhabi issued the second MYR 500 million ($160 million) tranche under its MYR 1.5 billion ($485 million) programme. With a tenor of 10 years, the second tranche pays 4.9 per cent and follows a similar issuance by the bank in June.
This month, the sukuk market may witness the issuance of sukuk by Nakheel. The fourth sukuk by the company could well be of benchmark size and is expected to be used to repay part of the company's existing debt.
“It would also signal renewed confidence in the debt markets from the company, which had trouble honoring its benchmark $3.5 billion sukuk,” Adnan Halawi Zawya senior sukuk analyst, said.
S&P believes that the sukuk market has grown large enough to support a transformation in the Islamic fund industry.
Sukuk funds are increasingly popular among investors as they produce fixed-income returns similar to those from traditional fixed-income investment products.
Sukuk funds also help investors to diversify away from pure equity and real estate funds, which suffered heavily during the last credit cycle.
The sukuk market has also recently been showing good performance with strong growth in total returns. This is at a time when other asset returns have been quite volatile.
From a demand perspective, it makes sense to buy sukuk in order to diversify the portfolio. For the supply side, sukuk offers an alternative source of funding to finance a business’ capital structure.
This could especially be important for the many family owned small and medium enterprises (SMEs) in the UAE and Dubai who has been having difficulty in accessing capital bilaterally.
However, it is still unlikely for SMEs to access the sukuk market any time soon. Because of the relative infancy of the product, sukuk documentation is often highly negotiated and is based on no existing template, making the process costlier than conventional bonds and other securities.
To justify the cost structure, the ideal size of a sukuk needs to be at least $500 million. This is because documentation cost tends to be fixed at $100,000-250,000 per issuance, a negligible cost if the issue is sizeable.
The costs of structuring and issuing sukuk is therefore high relative to conventional bank loans and bond issuance. Legal and accounting fees contribute to this higher cost structure, as does uncertainty regarding the perceived risk associated with these instruments.
Room for growth
From 2009 to date, the majority of issuance has been by governments and related entities, followed by corporations and then by financial institutions.
The sovereign issuance helps create a government yield curve aiding in the development of the global sukuk market.
While the sovereign issuance is important, there is a big room for growth as corporations currently lag behind in issuance.
Attracting more corporate issuers could mean a further broadening of the global sukuk market and could generate interest by more investors as the opportunities become more diversified.
In the long-run, the global sukuk market can be expected to follow the growth pattern of other major markets, with corporate issuance increasing following the growth of government issuance.
Given these demand and supply side prospects, any location where the two can be seamlessly connected would benefit greatly by attracting a large amount of business.
“Dubai with its strategic position as global financial hub, proximity to the wealthy GCC countries and time zone advantages can offer such a location,” Dubai Chamber, said.
Another important step can be to attract sovereign issuers from GCC countries to Dubai. In financial markets greater liquidity attracts even more issuance creating a virtuous cycle.
“Attracting sovereign issuers from the GCC could then help attract the second wave of sukuk issuance by GCC corporations making Dubai the centre for GCC sukuk issuance. These measures could help make Dubai the centre of MENA region and global sukuk issuance,” the report said.
Sukuk have gained prominence in the UAE lately as the demand for investment vehicles in conformance with Islamic laws has met issuance by government and corporate entities. The UAE is considered one of the top locations for sukuk issuance around the world and has created a transparent and benign environment forsukuk issuance and trading.
However, further progress in attracting large amounts of business can be made by establishing more transparency regarding sukuk laws and rulings, Dubai Chamber acknowledged.
It can be remembered that during the height of the Dubai World/Nakheel debt restructuring saga, the complexity of determining on whether a sukuk is asset-based or asset backed was exposed.
Some have presumed that Islamic finance instruments are always backed by assets; hence they can recover a part of their investments from the proceeds of the asset sale should there be a default on the side of the issuer.
Basically, the difference between being asset based and asset backed lies in ownership and sale of assets. Asset-based sukuk allow the inclusion of assets that may not be legally recognised as being owned by the investors.
The assets fulfill Shariah compliance in form. But they may not ensure that investors can recover capital, through sale of the asset, for example, in the case of originator bankruptcy.
Asset-backed sukuk on the other hand stick more closely to the ideal of granting the investor a share of a concrete asset or business venture, and a share of the risk commensurate with such ownership.
In this case, sukuk securitisation is structured around investors' rights, or legal ownership, of a plot of land, building, or other asset.
Regulators however insist that it was unlikely that investors were deceived to buy asset-based sukuks on the knowledge that they are asset-backed, especially because most of the investors are large funds, which are usually sophisticated.
The ambiguity does not end there.
Could the sukuk holders access those assets if they wanted to make that claim? And would they want to make a claim, in the first place, considering assets often include real estate in jurisdiction, whose worth is likely to have dived and they may be in jurisdiction where sukuk holders may have difficulty in having access.
Effectiveness of the existing Shari'a governance framework, as well as synthetic product structures commonly in use are also under discussion.
“Having achieved the critical volume estimated at $1 trillion in Islamic assets, the question reverberating across board rooms, and among users of Islamic financial services, is about differentiation, or the lack thereof, that Islamic financial institutions have on offer,” Ashar Nazim, Executive Director and Mena Head of Islamic Financial Services Group at Ernst & Young, said.
Scarcity of data and under-investment in analytical tools means that Islamic banks' focus remains limited to a handful of asset classes while their operating costs are, in many cases, higher than their conventional peers.
“Future opportunities may no longer come from traditional captive clientele. Instead, Islamic financial institutions urgently need to upgrade their business models to tap mainstream segments,” Nazim said.